F E D E R A L R E S E R V E S Y S T E M
Interest Rate Control
Is More Complicated
Than You Thought
By Stephen Williamson
M ost people are aware that decisions
by the Federal Reserve (Fed) affect
market interest rates. These decisions have
consequences for the interest rates that con-
sumers pay on mortgage loans, credit cards
and auto loans, and for the interest rates
faced by businesses on bank loans, corpo-
rate bonds and commercial paper.
But there is more than one interest rate
that the Fed sets, either as a target or by
administrative fiat. Many people are aware
of the target for the federal funds rate, or fed
funds rate, that the Federal Open Market
Committee (FOMC) of the Fed sets at its
eight regular meetings a year. The fed funds
rate is an interest rate on overnight credit
arrangements among financial institu-
tions—that is, a very short-term interest
rate. The Fed also sets the discount rate, or
the interest rate on primary credit, which
is an interest rate at which the Fed lends
to commercial banks in its role as a lender
of last resort. Still another rate is that on
interest paid by the Fed on reserves. Banks
hold reserve accounts with the Fed; these
accounts essentially play the role of checking
accounts for financial institutions. (A reserve
account is useful when a bank needs to make
large payments to other financial institu-
tions.) Thus, a reserve account is a loan to the
Fed from a bank. Before late 2008, reserve
accounts paid zero interest, as dictated by
Congress in the Federal Reserve Act.
Prior to the financial crisis (late 2007
through 2008), the Fed conducted monetary
policy within what economists call a chan-
nel system. The Fed targeted the overnight
fed funds rate within a “channel,” with the
discount rate as the upper bound on the
channel and the interest rate on reserves
as the lower bound on the channel. For
Also by Stephen Williamson
The St. Louis Fed has just released its annual report.
The main essay, written by Williamson, is about the
Fed’s return to normal monetary policy after seven
years of abnormally low interest rates. St. Louis Fed
President and CEO James Bullard also addresses this
topic. Elsewhere in the annual report, the St. Louis
Fed’s work, people, mission and results are featured.
To read the report online, go to www.stlouisfed.org/
annual-report.
example, in January 2007, the discount rate
was set at 6.25 percent, the fed funds rate was
targeted at 5.25 percent and the interest rate
on reserves was 0 percent. The fed funds rate
could not, in principle, go above the discount
rate because no bank would choose to borrow
from another bank at an interest rate higher
than the rate at which it could borrow from
the Fed (the discount rate). Similarly, no bank
would lend to another bank at an interest rate
lower than the interest rate it could receive
from the Fed (the interest rate on reserves).
In 2007, the New York Fed would intervene
every day in financial markets—through open
market operations, which are the purchase
and sale of assets by the Fed—to try to bring
the fed funds rate as close as possible
to the target set by the FOMC.
©FEDERAL RESERVE BOARD OF GOVERNORS
But between 2007 and now, the details
of how the Fed conducts monetary policy
have changed in important ways. First, since
late 2008, the reserves held at the Fed by
financial institutions have earned interest;
such interest payments are allowed under
an amendment to the Federal Reserve Act
passed by Congress. Further, and more
importantly, the interest rate on excess
reserves, or IOER, is set by the Fed and
can be changed over time.
Second, during the Great Recession (late
2007 to mid-2009) and its aftermath, the Fed
engaged in some unconventional monetary
policy actions. For our purposes, the most
important of these was a program of large-
scale asset purchases, sometimes known as
quantitative easing. This program led to a
large increase in the stock of reserves at the
Fed—effectively, the Fed purchased a large
quantity of assets (U.S. Treasury securities
and agency mortgage-backed securities) by
issuing more reserves.
For the Fed, the large stock of reserves
outstanding implies that monetary policy
works differently now—within a floor
system rather than a channel system. In a
floor system, the IOER plays a key role. In
principle, what should happen in a floor
system is that, with plenty of reserves in the
system, the Fed can achieve its target for the
fed funds rate by simply setting the IOER.
Why? If the fed funds rate were lower than
the IOER, then banks would be able to make
a profit from borrowing on the fed funds
market and lending to the Fed at the IOER,
thus forcing up the fed funds rate. If the fed
funds rate were higher than the IOER, then
a bank wanting to lend would earn more
interest on the fed funds market than by
lending to the Fed at the IOER. The large
The Regional Economist | www.stlouisfed.org 15
demand for fed funds would then force the FIGURE 1
fed funds rate down. Value of ON-RRPs Outstanding
According to this logic, controlling the 500
fed funds rate should be easy for the Fed Dec. 31

under a floor system. But theory and reality 400

sometimes do not agree. From late 2008 to

Billions of Dollars
300
December 2015, the IOER was set at 0.25 per-
cent. However, contrary to what many people 200
might think, since early 2009 the fed funds
rate has generally been 5 to 20 basis points 100
(one basis point is equal to 0.01 percentage
0
points) lower than the IOER. This difference

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01/04/16

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01/19/16

01/22/16
between the IOER and the fed funds rate is
typically ascribed to costs for commercial
banks associated with borrowing on the fed SOURCES: Federal Reserve Board/Haver Analytics. NOTE: ON-RRP stands for overnight reverse repurchase agreement.
funds market.1
The persistent difference between the
FIGURE 2
IOER and the fed funds rate was a concern
A Floor and a Subfloor for the Federal Funds Rate
for the Fed as it anticipated the time when
“liftoff” would occur, where liftoff refers 0.6

to the date at which the Fed would depart 0.5

from its long period (since late 2008) of
0.4
Percent Per Annum

zero interest rate policy, or ZIRP. Could the

Fed expect that the fed funds rate would 0.3
increase along with the IOER if the Fed 0.2
attempted to control the fed funds rate only Dec. 31
through increases in the IOER? 0.1
IOER Federal Funds Rate ON-RRP Rate
The solution adopted by the Fed is unique 0.0
12/17/15

12/19/15

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12/25/15

12/27/15

12/29/15

12/31/15

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01/04/16

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01/18/16

in central banking—a floor system with a
subfloor. The New York Fed, in intervening
in overnight financial markets, is now mak-
ing use of an overnight reverse repurchase
agreement (ON-RRP) facility. ON-RRPs are
essentially reserves by another name. In ON-
RRP transactions, financial institutions lend
to the Fed, just as they do when they hold
reserve accounts with the Fed. The difference
between reserves and ON-RRPs is that, in an
ON-RRP arrangement, the Fed posts securi-
ties in its portfolio as collateral, just as in any
private repurchase agreement transaction.
A repurchase agreement is simply a special
kind of financial market loan that is secured
by collateral just as, for example, your mort-
gage is secured by your house, which can be
seized if you default on the mortgage.
Without getting into all the details,2 the
idea behind the floor-with-subfloor system
is that the Fed sets, along with the discount
rate and IOER, an ON-RRP rate, which is
the rate at which financial institutions can
lend to the Fed in the market for repurchase
agreements. The ON-RRP rate is set below
the IOER, and then policy is announced as a
target range for the fed funds rate, with the
16 The Regional Economist | April 2016
01/20/16
SOURCES: Federal Reserve Board/Haver Analytics.
NOTE: In principle, the large stock of reserves outstanding should result in the fed funds rate equaling the interest on excess
reserves (IOER), but economic factors have resulted in the former rate running below the latter. The rate for overnight reverse
repurchase agreements (ON-RRP) should serve as a secondary floor for the fed funds rate, and it largely has. The only time
the fed funds rate has fallen below the ON-RRP rate since liftoff was Dec. 31, 2015, and this is likely explained, in part, by
the fact that financial reporting took place on that day and the fact that there are differences in the time frames of fed funds
and ON-RRP transactions.
top of the range given by the IOER and the funds rate has typically been within a tight
bottom of the range determined by the ON- range of 0.35-0.37 percent, except on Dec. 31,
RRP rate. Thus, the IOER sets the floor, and 2015, when the average rate was 0.20 per-
the ON-RRP rate sets the subfloor. cent. Thus, in terms of results, the Fed has
But could this system work? On Dec. 16, been successful in controlling the fed funds
2015, the FOMC decided to increase the rate within the 0.25-0.50 percent range.
target range for the federal funds rate from But why was the average fed funds rate
0-0.25 percent to 0.25-0.50 percent, 3 with so low and the ON-RRP quantity so high
the discount rate at 1.0 percent, the IOER on Dec. 31, 2015? This date was both the
at 0.50 percent and the ON-RRP rate set at quarter-end and year-end, which is impor-
0.25 percent. tant because at this time financial reporting
As shown in Figure 1, the value of takes place and financial institutions want to
ON-RRPs outstanding increased from have their balance sheets appear as favorable
$105 billion on Dec. 17, 2015, to $475 billion as possible to their shareholders and regula-
on Dec. 31, following which the quantity tors. Lending on the fed funds market can be
dropped back to the neighborhood of a risky activity, as lending is unsecured, while
$100 billion. In the fed funds market, as lending to the Fed in the form of ON-RRPs
shown in Figure 2, the average daily fed is essentially riskless. Therefore, we might
 E C O N O M Y A T A G L A N C E

expect that, on Dec. 31, lenders in the over- REAL GDP GROWTH CONSUMER PRICE INDEX (CPI)
night market would shift their activity from 6 4
CPI–All Items
the fed funds market to the ON-RRP market,

PERCENT CHANGE FROM A YEAR EARLIER

All Items, Less Food and Energy
as this would reduce risk on their balance 4
sheets. Sure enough, we saw a large increase 2

in ON-RRP activity on Dec. 31.

PERCENT
2
Still, why were fed funds market lenders
0
accepting an average interest rate of 0.20 0
percent on Dec. 31, 2015, which is lower
than the ON-RRP rate on that date, and why –2
Q4 March
–2
were some participants accepting interest ’10 ’11 ’12 ’13 ’14 ’15 ’11 ’12 ’13 ’14 ’15 ’16
rates as low as 0.08 percent? A potential NOTE: Each bar is a one-quarter growth rate (annualized);
the red line is the 10-year growth rate.
explanation for this is that fed funds market
trades and ON-RRP trades are very differ- I N F L AT I O N - I N D E X E D T R E A S U RY Y I E L D S P R E A D S RATES ON FEDERAL FUNDS FUTURES ON SELECTED DATES
ent in terms of the time of the day lending 3.00 0.8
occurs and when the loan is paid back the 10/28/15 1/27/16
2.75 0.7
next day. In particular, ON-RRP borrow- 12/16/15 3/16/16
2.50 0.6
ing by the Fed occurs between 12:45 and
2.25 0.5
1:15 p.m. ET, and loans are paid back the
PERCENT

PERCENT
2.00 0.4
next day between 3:30 and 5:15 p.m. ET. April 8, 2016
1.75 0.3
However, a fed funds transaction can occur 20-Year
1.50
as late as 6:30 p.m., with funds potentially 10-Year
0.2

returned early the next day.4 So, while a fed 1.25 0.1
5-Year
funds market transaction may be riskier 1.00
’12 ’13 ’14 ’15 ’16
0.0
1st-Expiring 3-Month 6-Month 12-Month
because lending is unsecured, it is also more NOTE: Weekly data. Contract
CONTRACT SETTLEMENT MONTH
liquid, as lending can occur later in the day
and funds can be returned more quickly the C I V I L I A N U N E M P L O Y M E N T R AT E I N T E R E S T R AT E S
next day. Thus, lenders may be willing to pay 10 4
10-Year Treasury
for liquidity with a lower overnight interest 9
rate, and this would have a larger effect at 3
8
the quarter-end, when trading on the fed
7
funds market is thin.
PERCENT

PERCENT

2
6

5
1
Stephen Williamson is an economist at the Fed Funds Target
February
4
Federal Reserve Bank of St. Louis. For more on 1-Year Treasury
March
his work, see https://research.stlouisfed.org/econ/ 3 0
williamson. Research assistance was provided ’11 ’12 ’13 ’14 ’15 ’16 ’11 ’12 ’13 ’14 ’15 ’16
by Jonas Crews, a research analyst at the Bank. NOTE: On Dec. 16, 2015, the FOMC set a target range for the
federal funds rate of 0.25 to 0.5 percent. The observations
plotted since then are the midpoint of the range (0.375 percent).

U.S. AGRICULTURAL TRADE AVERAGE LAND VALUES ACROSS THE EIGHTH DISTRICT
ENDNOTES
1 See Williamson. 90 6
Exports
2 See Williamson for more information. Quality Farmland
YEAR-OVER-YEAR PERCENT CHANGE

3 See Board of Governors. 75 4

4 See Bartolini, Hilton and McAndrews for more Imports
Ranchland or Pastureland
BILLIONS OF DOLLARS

60 2
information on the timing of transactions.

45 0
REFERENCES
30 –2
Bartolini, Leonardo; Hilton, Spence; and McAndrews,
James. “Settlement Delays in the Money Market.”
New York Federal Reserve Bank Staff Reports, 2008, 15 –4
Trade Balance
No. 319. See www.newyorkfed.org/medialibrary/ February
media/research/staff_reports/sr319.pdf. 0 –6
Board of Governors of the Federal Reserve System. Press ’11 ’12 ’13 ’14 ’15 ’16 2014:Q4 2015:Q1 2015:Q2 2015:Q3 2015:Q4
Release, Dec. 16, 2015. See www.federalreserve.gov/ NOTE: Data are aggregated over the past 12 months. SOURCE: Agricultural Finance Monitor.
newsevents/press/monetary/20151216a.htm.
Williamson, Stephen D. “Monetary Policy Normali-
zation in the United States.” Federal Reserve Bank
of St. Louis Review, 2015, Vol. 97, No. 2, pp. 87-108. On the web version of this issue, 11 more charts are available, with much of those charts’ data specific to the Eighth District.
See https://research.stlouisfed.org/publications/ Among the areas they cover are agriculture, commercial banking, housing permits, income and jobs. To see those charts, go to
review/2015/q2/Williamson.pdf. www.stlouisfed.org/economyataglance.

The Regional Economist | www.stlouisfed.org 17